The dangers of digital assets and tokenisation

There are pressing questions around digital assets and tokenisation that need to be answered before widespread adoption occurs among incumbent market players, not to mention a wide range of risk considerations, writes Virginie O’Shea founder of Firebrand Research.

In general, I am in favour of the move to a more digitally-enabled capital markets setup, but there are important risk considerations to factor into the creation of digital assets or tokens that I feel current discourse doesn’t always mention.

I am cognisant that my scepticism around cryptocurrencies could be dismissed as overly cautious by the infamous “crypto bro” community, especially the rather vocal denizens on Twitter. For a start, the asset valuations all seem to move in step with each other, which is less than optimal from the market risk mitigation perspective. Hedge funds might be able to nip in and out of the markets as they need, but your slower moving, longer holding institutional investors are unlikely to benefit from large exposures to such volatility in the long term.

But the correlation risks of your Dogecoin, Bitcoin, Anothercoin aside, the digitalisation of fiat currencies could potentially be helpful to the digital transformation agenda within the central banking space. A well-timed boot in the posterior to a relatively slow-moving part of the financial services sector could get some of these initiatives moving. Whether they succeed or not is another matter, but if you don’t try, you don’t ever know if you could succeed. I wait with anticipation to see whether these digital currencies actually result in tangible benefits to the industry at large with the same degree of anticipation I have around the benefits of distributed ledgers replacing existing equities settlement infrastructure (but I’ll save that for another day).

The more concerning area in the short term is the push from certain corners of the market to tokenise illiquid assets in a bid to improve their fungibility. This brings to my mind the packaging up of dodgy mortgages that preceded our last financial crisis. There are some questions that need to be asked and answered before we begin tokenising everything under the sun and expecting market liquidity to automatically improve as a result:

  • Does turning an asset into a token change the nature of that asset?
  • Does it make it more liquid in volatile markets? Does it increase the chance of a counterpart buying that asset if significant market turbulence occurs?
  • Does it increase the number of potential buyers for that asset to such an extent that the liquidity risk considerations change?
  • If the answer to all of these questions is ‘no’, then should we bother tokenising the asset at all?

The danger here is that investors may be seduced by the appeal of a tokenised asset as fear of missing out (FOMO) sets in. They may not ask the right questions about whether it is a safe and secure investment for the long term. Tokenisation could have benefits but it also poses risks and these need to be considered in their entirety before we head down this path. At the very least, we need to make sure risks are managed appropriately.